Central banks are addressing their role as Lender of Last Resort (LOLR) by expanding liquid assets and lending much more generously since the economic crisis hit in August 2007, and according to the Federal Reserve Bank of New York, that’s exactly what they should  be doing. Two economists at Bank for International Settlements , Stephen Cecchetti and Piti Disyatat, outlined in their research paper “Central Banking Tools and Liquidity Shortages” the traditional tools that central banks use to mitigate financial instability nationally or regionally. According to Cecchetti and Disyatat, there are three different types of liquidity shortages: shortage central bank liquidity, acute shortage funding liquidity at specific institutions and systematic shortage funding and market liquidity. Different types of liquidity shortages can happen simultaneously. Cecchetti and Disyatat said the central banks of the world can reset the balance in liquidity by lending to the open market, buying from the open market or targeting financial transactions towards specific institutions instead of the market as a whole. A shortage of central bank liquidity occurs when institutions find themselves short on reserve balances. This is usually caused by a spike in overnight interest rates, a computer glitch or an inadequate supply of reserves to the system as a whole. It is the least threatening shortage of the three and the central bank acquires virtually no risk in lending to the open market. The second kind of liquidity shortage occurs when a particular institution experiences an acute shortage of funding liquidity associated with solvency concerns as the willingness of counterparties to trade with the institution dissipates. This situation can arise as the result of a flawed business strategy that has left the institution exposed to persistent cash drains. Any liquidity support extended in this situation will likely expose the central bank to credit risk, since an institution in need of a loan of last resort will typically have exhausted its stock of both marketable assets and acceptable collateral. A systematic shortage of funding and market liquidity is potentially the most destructive of the three. It involves tensions emanating from an evaporation of confidence and from coordination failures among market participants that lead to a breakdown of key financial markets. This kind of shortage can produce a “run” on the bank when consumers lose confidence. Since the origination of the financial crisis, central banks are following standard LOLR procedures for all three shortages. With regard to central liquidity shortages, Cecchetti and Disyatat said banks are accommodating the greater instability in the demand for reserves and alleviating distributional problems by varying the size and frequency of operations. That broadens the number and type of counterparts and enlarges the scope of eligible collateral to lend to financial institutions. For acute shortages of funding liquidity at specific institutions, central banks have extended emergency lending assistance to various financial institutions. Take for example the Federal Reserve’s support for Bear Stearns, AIG, and Citigroup. Cecchetti and Disyatat named four crucial actions the central banks are taking to stabilize the systematic shortage of funding and market liquidity.

• Central banks seek to ensure the availability of backstop liquidity to key financial institutions. For example, central banks created of the Federal Reserve’s PDCF, which established overnight funding for primary dealers.

• Central banks are providing greater assurance of the availability of term funding through the lengthening of the maturity on refinancing operations as well as the establishment of inter-central-bank swap lines to ensure the availability of (primarily) dollar funding in offshore markets.

• Policymakers have worked to provide high-quality securities — usually sovereign ones — in exchange for lower quality, less liquid securities in order to encourage trading in the latter.

• The banks have also established initiatives aimed at ensuring the availability of credit to non-banks in cases where particular financial markets had become inoperative.

These policy implementations were applied in two phases the first of which being August 2007 through September 2008. During that time centrals banks varied the asset composition of their balance sheets, but kept the overall size of assets largely the same. As the crisis intensified following the collapse of Lehman Brothers, central bank operations entered a second phase where they expanded their balance sheets and increased the size as well as scope of their efforts in market functionality. This shift is visible in the chart below. Cecchetti and Disyatat concluded the central banks’ ability to mitigate the current economy must be flexible to follow and provide exactly what the market needs to avoid disastrous liquidity shortage. “The current crisis has made it abundantly clear that the argument that only open market operations are needed to meet the liquidity needs of fundamentally sound banks is flawed since money markets themselves can fail to function properly,” said the report. “This is even more so in light of recent developments in the financial system that have increased the interdependencies between financial institutions and markets, and made it more imperative that central banks be prepared for situations in which both experience problems simultaneously.” Write to Christine Ricciardi.